Introduction:

Financial Accountants are busy with recording of transactions and

preparation of Profit & loss Account and Balance sheets and various reports
and disclosures as per the requirements of banks and income tax and other
authorities. A specialized branch is necessary which can concentrate on cost
and cost related areas and that is why Cost Accounting has come into the
picture. To overcome from the drawbacks of Financial Accounting, Cost
Accounting was developed.

Cost : the amount of expenditure (actual or notional) incurred on or

attributable to a given thing or to ascertain the cost of a given thing.

Costing
System of computing cost of production or of running a business, by
allocating expenditure to various stages of production or to different
operations of a firm.

Cost Accounting
Cost Accounting is an expanded phase of financial accounting which provides
management promptly with the cost of producing and/or selling each
product and rendering a particular service.

Elements of Cost

Following are the three broad elements of cost:

1. Material

The substance from which a product is made is known as material. It

may be in a raw or a manufactured state. It can be direct as well as
indirect.

a. Direct Material

The material which becomes an integral part of a finished

product and which can be conveniently assigned to specific
physical unit is termed as direct material. Following are some of
the examples of direct material:

 All material or components specifically purchased,

produced or requisitioned from stores
 Primary packing material (e.g., carton, wrapping,
cardboard, boxes etc.)
  Purchased or partly produced components

Direct material is also described as process material, prime cost

material, production material, stores material, constructional
material etc.

b. Indirect Material

The material which is used for purposes ancillary to the business

and which cannot be conveniently assigned to specific physical
units is termed as indirect material. Consumable stores, oil and
waste, printing and stationery material etc. are some of the
examples of indirect material.

Indirect material may be used in the factory, office or the selling

and distribution divisions.

2. Labor

For conversion of materials into finished goods, human effort is needed

and such human effort is called labor. Labor can be direct as well as
indirect.

a. Direct Labor

The labor which actively and directly takes part in the production
of a particular commodity is called direct labor. Direct labor costs
are, therefore, specifically and conveniently traceable to specific
products.

Direct labor can also be described as process labor, productive

labor, operating labor, etc.

b. Indirect Labor

The labor employed for the purpose of carrying out tasks

incidental to goods produced or services provided, is indirect
labor. Such labor does not alter the construction, composition or
condition of the product. It cannot be practically traced to specific
units of output. Wages of storekeepers, foremen, timekeepers,
directors’ fees, salaries of salesmen etc, are examples of indirect
labor costs.

Indirect labor may relate to the factory, the office or the selling
and distribution divisions.
3. Expenses

Expenses may be direct or indirect.

a. Direct Expenses

These are the expenses that can be directly, conveniently and

wholly allocated to specific cost centers or cost units. Examples of
such expenses are as follows:

 Hire of some special machinery required for a particular

contract
 Cost of defective work incurred in connection with a
particular job or contract etc.

Direct expenses are sometimes also described as chargeable

expenses.

b. Indirect Expenses

These are the expenses that cannot be directly, conveniently and

wholly allocated to cost centers or cost units. Examples of such
expenses are rent, lighting, insurance charges etc.

4. Overhead

The term overhead includes indirect material, indirect labor and

indirect expenses. Thus, all indirect costs are overheads.

A manufacturing organization can broadly be divided into the

following three divisions:

o Factory or works, where production is done

o Office and administration, where routine as well as policy
matters are decided
o Selling and distribution, where products are sold and finally
dispatched to customers

Overheads may be incurred in a factory or office or selling and

distribution divisions. Thus, overheads may be of three types:

a. Factory Overheads

They include the following things:

  Indirect material used in a factory such as lubricants, oil,
consumable stores etc.
 Indirect labor such as gatekeeper, timekeeper, works
manager’s salary etc.
 Indirect expenses such as factory rent, factory insurance,
factory lighting etc.
b. Office and Administration Overheads

They include the following things:

 Indirect materials used in an office such as printing and

stationery material, brooms and dusters etc.
 Indirect labor such as salaries payable to office manager,
office accountant, clerks, etc.
 Indirect expenses such as rent, insurance, lighting of the
office
c. Selling and Distribution Overheads

They include the following things:

 Indirect materials used such as packing material, printing

and stationery material etc.
 Indirect labor such as salaries of salesmen and sales
manager etc.
 Indirect expenses such as rent, insurance, advertising
expenses etc.

Classification of Cost

Cost may be classified into different categories depending upon the purpose
of classification. Some of the important categories in which the costs are
classified are as follows:

1. Fixed, Variable and Semi-Variable Costs

The cost which varies directly in proportion with every increase or decrease in
the volume of output or production is known as variable cost. Some of its
examples are as follows:

 Wages of laborers
 Cost of direct material
  Power

The cost which does not vary but remains constant within a given period of
time and a range of activity inspite of the fluctuations in production is known
as fixed cost. Some of its examples are as follows:

 Rent or rates
 Insurance charges
 Management salary

The cost which does not vary proportionately but simultaneously does not
remain stationary at all times is known as semi-variable cost. It can also be
named as semi-fixed cost. Some of its examples are as follows:

 Depreciation
 Repairs

2. Product Costs and Period Costs

The costs which are a part of the cost of a product rather than an expense of
the period in which they are incurred are called as “product costs.” They are
included in inventory values. In financial statements, such costs are treated as
assets until the goods they are assigned to are sold. They become an expense
at that time. These costs may be fixed as well as variable, e.g., cost of raw
materials and direct wages, depreciation on plant and equipment etc.

The costs which are not associated with production are called period costs.
They are treated as an expense of the period in which they are incurred. They
may also be fixed as well as variable. Such costs include general
administration costs, salaries salesmen and commission, depreciation on office
facilities etc.

3. Direct and Indirect Costs

The expenses incurred on material and labor which are economically and
easily traceable for a product, service or job are considered as direct costs. In
the process of manufacturing of production of articles, materials are
purchased, laborers are employed and the wages are paid to them. Certain
other expenses are also incurred directly. All of these take an active and direct
part in the manufacture of a particular commodity and hence are called direct
costs.

The expenses incurred on those items which are not directly chargeable to
production are known as indirect costs. For example, salaries of timekeepers,
storekeepers and foremen. Also certain expenses incurred for running the
administration are the indirect costs. All of these cannot be conveniently
allocated to production and hence are called indirect costs.

4. Decision-Making Costs and Accounting Costs

Decision-making costs are special purpose costs that are applicable only in the
situation in which they are compiled. They have no universal application.
They need not tie into routine-financial accounts. They do not and should not
conform the accounting rules. Accounting costs are compiled primarily from
financial statements. They have

5. Relevant and Irrelevant Costs

Relevant costs are those which change by managerial decision. Irrelevant costs
are those which do not get affected by the decision. For example, if a
manufacturer is planning to close down an unprofitable retail sales shop, this
will affect the wages payable to the workers of a shop. This is relevant in this
connection since they will disappear on closing down of a shop. But prepaid
rent of a shop or unrecovered costs of any equipment which will have to be
scrapped are irrelevant costs which should be ignored.

6. Shutdown and Sunk Costs

A manufacturer or an organization may have to suspend its operations for a

period on account of some temporary difficulties, e.g., shortage of raw
material, non-availability of requisite labor etc. During this period, though no
work is done yet certain fixed costs, such as rent and insurance of buildings,
depreciation, maintenance etc., for the entire plant will have to be incurred.
Such costs of the idle plant are known as shutdown costs.

Sunk costs are historical or past costs. These are the costs which have been
created by a decision that was made in the past and cannot be changed by any
decision that will be made in the future. Investments in plant and machinery,
buildings etc. are prime examples of such costs. Since sunk costs cannot be
altered by decisions made at the later stage, they are irrelevant for decision-
making.

7. Controllable and Uncontrollable Costs

Controllable costs are those costs which can be influenced by the ratio or a
specified member of the undertaking. The costs that cannot be influenced like
this are termed as uncontrollable costs.

8. Avoidable or Escapable Costs and Unavoidable or Inescapable Costs

Avoidable costs are those which will be eliminated if a segment of a business
(e.g., a product or department) with which they are directly related is
discontinued. Unavoidable costs are those which will not be eliminated with
the segment. Such costs are merely reallocated if the segment is discontinued.
For example, in case a product is discontinued, the salary of a factory manager
or factory rent cannot be eliminated.

9. Imputed or Hypothetical Costs

These are the costs which do not involve cash outlay. They are not included in
cost accounts but are important for taking into consideration while making
management decisions. For example, interest on capital is ignored in cost
accounts though it is considered in financial accounts. In case two projects
require unequal outlays of cash, the management should take into
consideration the capital to judge the relative profitability of the projects.

10. Differentials, Incremental or Decrement Cost

The difference in total cost between two alternatives is termed as differential

cost. In case the choice of an alternative results in an increase in total cost,
such increased costs are known as incremental costs. While assessing the
profitability of a proposed change, the incremental costs are matched with
incremental revenue. This is explained with the following example:

11. Out-of-Pocket Costs

Out-of-pocket cost means the present or future cash expenditure regarding a

certain decision that will vary depending upon the nature of the decision
made. For example, a company has its own trucks for transporting raw
materials and finished products from one place to another. It seeks to replace
these trucks by keeping public carriers. In making this decision, of course, the
depreciation of the trucks is not to be considered but the management should
take into account the present expenditure on fuel, salary to driveRs and
maintenance. Such costs are termed as out-of-pocket costs.

12. Opportunity Cost

Opportunity cost refers to an advantage in measurable terms that have

foregone on account of not using the facilities in the manner originally
planned. For example, if a building is proposed to be utilized for housing a
new project plant, the likely revenue which the building could fetch, if rented
out, is the opportunity cost which should be taken into account while
evaluating the profitability of the project. Suppose, a manufacturer is
confronted with the problem of selecting anyone of the following alternatives:
 a. Selling a semi-finished product at Rs. 2 per unit
b. Introducing it into a further process to make it more refined and
valuable

14. Production, Administration and Selling and Distribution Costs

A business organization performs a number of functions, e.g., production,

illustration, selling and distribution, research and development. Costs are to
be curtained for each of these functions.

15. Conversion Cost

The cost of transforming direct materials into finished products excluding

direct material cost is known as conversion cost. It is usually taken as an
aggregate of total cost of direct labor, direct expenses and factory overheads.